Opinion: Watch for inflationary expectations

By BNZ Markets Senior Markets Economist Craig Ebert It was a relief that July's food prices increased no faster than the 0.6% confirmed in this morning's published data. Annual inflation actually came off a bit, to 7.6%, from June's 8.2%. However, the underlying pace remains a headache for the central bank and consumers alike. As much as food prices are maintaining upward pressure on headline CPI inflation, they are just as surely continuing to squeeze household budgets. And these conflicting pressures are likely to get worse before they get any better, with this winter of extreme rain, cold and snow hampering local food production. This threatens to drive vegetable prices, in particular, even higher until such time supply can bounce back. Indeed, because of the talked-about disruptions for food growers, we have actually nudged up our expectations of Q3 food price inflation to 2.2%, in spite of the as-expected results for July (which, itself, included a 3.6% monthly increase in fruit and vegetable prices). This pressure might flow into the Q4 CPI as well.

For the meantime, however, we have sufficed in rounding our Q3 CPI estimate back up to 1.3% (previously moderated to 1.2% on the back of reversing petrol prices). This implies annual inflation will spike to 4.9%, from the 4.0% reported for the June quarter. We still expect this to be the peak, with annual inflation easing back to 4.0% by early next year and to 2.4%over the year to March 2010. The trick in the interim will be to not confuse the near-term commodity inflation, influenced, as it will be, by supply shocks (including, now, adverse local weather, not just matters international) with the thrust of demand-driven inflation. The latter, of course, remains the most relevant from the central bank’s (medium-term) perspective, notwithstanding the risk of inflation expectations reacting adversely to spiking CPI inflation in the first instance. And, to be sure, inflation expectations have crept up to uncomfortably high rates over recent years, to be testing the extremes of the Reserve Bank’s CPI target band. To get a feel for this, we need only check out tomorrow’s RBNZ Survey of Expectations. While we can imagine its one-year-ahead view on CPI inflation might have edged above the 3.3% result of May’s survey, we’d be surprised to see the (more instructive) two-year-ahead view moving clearly above the previously seen 2.9%. We say this with accumulating evidence that, against a backdrop of a clearly slowing world economy, the underlying pressures on domestic inflation have continued to wane over recent months. In particular, consumer spending continues to struggle, while the housing market still looks fundamentally weak to us (despite a recovery in home sales over the last couple of months). We expect this to be echoed in a still-decelerating trend in Thursday’s household credit figures for July. We anticipate the same primary weakness in Friday’s building consents, with the trend level still in retreat. All the same, do watch for a technical bounce in residential consents, given June’s result was so very low. The business sector has more recently suffered from the distress longer-felt in the household sector. We suppose this will be broadly reaffirmed in Wednesday’s August NBNZ business outlook. Sure, net confidence looks as though it has floated away from hell’s teeth, with the lower exchange rate, reversing fuel prices and even moderating interest rates obvious candidates for salvation. There might even be a lift in own-activity expectations, into slightly positive territory, following the unprecedented run of negatives over the five months to July. However, anything remotely average, let alone robust, on these counts still seems miles away (not to deny meaningful elements of support are starting to show through, with the examples of agriculture, fiscal policy and infrastructure). With this in mind, we’ll continue to put a lot of store in the NBNZ survey’s pointers to employment and investment. It’s where firms put their money, notwithstanding where their mouths might be. In respect of the jobs market, its path remains important as to how much relief we can expect in core  inflation and interest rates. And we get the distinct impression things are coming to the crunch. So we wouldn’t be surprised to see employment intentions remain at least as negative as the -13 registered in July’s NBNZ survey. As for business investment, we likewise believe there is definite weakness in the brewing (if not quite as stark as we detect in the labour market). So we can imagine July’s surveyed investment intentions were no better than the -4 reading of July. Yet if it becomes more lacklustre in Wednesday’s survey, we need to be wary of the supply-side restraint it portends, even with the pressure lower investment activity takes off the demand side of the economy over the nearer term. The other local data item for the week is tomorrow’s merchandise trade figures for July. These, to be honest, have become extremely hard to decipher of late, given commodity price gyrations, drought-affected export supply, trading day effects and signs of bloated inventories in domestic industries. Still, for the record, we expect goods exports of $3,300m (25% y/y) and imports of $4,070m (18% y/y), meaning a July deficit of $770m (around about the same shortfall as a year ago). It will take a significant surprise in the monthly trade data (excluding one-off transport items, that is) to have us changing our view on underlying economic activity. But, in this respect, we will certainly be watching for any clear warning that core import growth is starting to collapse, as we think is the big risk. While this might be an important source of restraint for New Zealand’s current account deficit, softening imports will fit our suspicions that domestic demand continues to wane, leaving an overhang of inventory that will feed back into lower activity at source. Such things will be important in lessening underlying inflation, even as local bad weather maintains upward pressure on an already ugly looking headline CPI picture for the near term. * This economic outlook was written by BNZ’s Senior Markets Economist Craig Ebert. A full version of this report with charts can be found here. All of the research from the BNZ Markets team of economists is available here.